XII. Keynesian stabilization in an open economy

XII. 1 Aggregate demand in the short run

Net export and real ExR• In the short-run, export depends on foreign

demand and real exchange rate, import depends on domestic AD and real exchange rate

• Usual assumption: Marshall-Lerner condition, i.e. net export depends on real exchange rate only (see Krugman, Obstfeld)

• Consequently, assume:– The lower the real exchange rate, the less

competitive domestic goods and services are, the higher the current account deficit (NX drops)

– And vice versa

0NX , eNXNX e

Aggregate demand and real ExR

• Considering relation between demand for real output and real ExR, ceteris paribus, i.e. when all other variables (interest, taxes, etc.) unchanged– and standard assumption: economy at the

potential output (full employment) equilibrium

• AD = C + I + G + NX , but if only Y and real ExR allowed to vary, we might schematically write AD = AD(Y,e)

Output determination in the short run

• Short run : prices (and wages) assumed fixed, than real ExR depends of nominal ExR only

• Closed economy in the short run: relation between output and interest (ISLM)

• Open economy in the short run: relation between output and ExR (interest considered as given)

• “ISLM-type” adjustment (see next slide):– Excess demand → inventories↓ → output↑– Excess supply, vice versa

• Combinations of output and ExR, keeping goods market in short run equilibrium: DD curve (see next slide again)

AD

Y

45o

1EAD

AD E2

ondepreciati - EE 12

1Y 2Y

Y

E

1Y 2Y

E1

E2

DD

What shifts DD curve?• In general: any disturbance, raising AD,

shifts DD to the right; disturbance, lowering AD, shifts DD to the left

• In our framework, following factors might be relevant:– Expenditures G, taxes T, investment I,

domestic price P, foreign price P*, changes in autonomous consumption, demand shifts between domestic and foreign goods

– Check yourself

XII.2 Asset market in the short run

Output and ExR on the asset market

• Asset market: interest parity condition

• Interest rate determined by equilibrium on domestic money market (see LXI):

• Short run: expectations, foreign interest rate, price and money supply given

• Infinite combinations of output and ExR, keeping asset market in equilibrium: AA curve (see next slide)

r r* Ee -E E

rY,LPMS

E

P

M

returns

Return on foreign deposits

P

MS

1r

r),L(Y1

1E

r),L(Y2

2r

2E

12 YY

E

Y2Y1Y

1E

2E

AA

What shifts AA curve?

• Change in domestic money supply MS

• Change in price P

• Change in expectations Ee

• Change in foreign interest rate r*

• Shifts in demand for money function

XII.3 Short run equilibrium in an open economy

Equilibrium and adjustment• Equilibrium both on goods and asset

market: intersection of DD and AA curves

• Adjustment speed: faster adjustment on assets market than on goods market

E

Y

DDAA

A

●C

●B

XII.4 Policies

XII.4.1 Temporary policies

• Short term policies, expected to be reversed in the future, i.e. expections remain constant

• Prices, wages, expectations fixed• Adjustment obvious – see above what

changes DD and AA curves

Monetary policy Fiscal policy

E

Y

DD

1AA

2AA

Y

E AA1DD

2DD

Use (and many warnings)

• Both expansionary monetary and fiscal policies– Increase output– Monetary → depreciation, fiscal →

appreciation

• Application: short term reaction to exogenous shocks

• Many pitfalls– Inflation bias– Time lags– Unclear origins of disturbances, etc.

XII.4.2 Permanent policies

• Policies that are not reversed → change of expected ExR

• Considering long term effects – after full adjustment of prices, wages and volumes

• Starting point – potential output, natural values, ExR expectation equals actual ExR → domestic interest equals “foreign” interest

Robert Mundell

• 1932 –• Stanford University• International

institutions (namely IMF)

• International economics

• Mundell-Fleming model

• Nobel price in 1999

                                           

Monetary policy• Money supply increase → shift of AA curve,

but larger than in case of temporary case– Shift due to MS increase– Shift due Ee increase

• Long term adjustment: price increase due to larger money supply (next slide: red color means final positions):– Real appreciation → domestic goods relatively

more expensive → fall of foreign demand → shift of DD curve “up and left”

– Real money supply falls → AA curve, after an initial shift „up“, shifts “down and left”

E

Y

AA1

DD1

Yf

E1

AA2

Y2

E2

DD2

AA3

E3

1

23

Monetary policy efficiency

• Long term adjustment:– Return to potential output– Higher price level– Nominal depreciation

• However – in the short term (within a concept of Keynesian policy stimulation) monetary policy is efficient– Increase of output and employment

• Remember ExR overshooting (see LXI)

Fiscal policy

• Permanent fiscal expansion– In reality usually accompanied by

permanent tax increase, otherwise unsustainable

– Remember: balanced budget multiplier = 1

• Open economy– Short term shift of DD curve “up and right”– Permanent fiscal change → increase of Ee

→ shift of AA curve “down and left”

E

Y

DD1

AA1

Yf

E1

DD2

AA2

1

X

2E2

Fiscal policy efficiency• Adjustment on the currency market

extremely fast → after initial DD shift, change in expectation moves the AA curve immediately „down“

• There is no increase of output (and employment) even in the short term (economy will never reach point X)

• Long term adjustment in closed economy– Return to potential output, government spending

crowds-out private investment, inflation• Open economy

– Remains at potential output at appreciated currency

– Aggregate demand for domestic product crowded-out by demand for foreign products (as they became cheaper)

• Fiscal policy inefficient

XII.5 Fixed exchange rate

Notice• When ExR fixed, but market pressures against

the fix, then Central Bank must intervene– Pressure towards appreciation → purchase of foreign

assets

– Pressure towards depreciation → sale of foreign assets

• Link between Central Bank intervention and money supply– Purchase of (foreign) assets → increase in money

supply

– Sale of (foreign) assets → decrease in money supply

Fixing the rate

• Commitment of Central Bank to trade domestic currency at given rate

• Why fix?– There is no ideal floating in reality– Arrangements for countries in a transitory

stage of economies– Lessons from the past– Regional currency areas (e.g. Euro)

Equilibrium under Fix• Fix – expected ExR equals actual one• Interest rate parity implies that domestic

interest must equal foreign interest• Implications for domestic money market –

e.g. in case of output increase:– Push towards increase of domestic interest rate

→ push towards appreciation– To keep currency fixed, Central Bank must

intervene → purchase of foreign assets → increase of money supply → interest rate and ExR remain at original levels

• Under fix – automatic accommodation of monetary policy

P

M

r

E

EE-Er e*

L(Y1,r)

P

M1

r1

E1

L(Y2,r)

P

M2

Stabilization policies under fix (1)

• Only short term effects, try to derive yourselves diagrammatically

• Monetary policies, e.g. increase of money supply by purchasing domestic assets → pressure towards decrease of interest and depreciation (shift in AA) → Central Bank must intervene selling foreign assets → decrease of money supply

• No effect on output and employment, but decrease in foreign reserves exactly equal to original purchase of domestic assets

Stabilization policies under fix (2)

• Fiscal expansion → increase of AD, shift of DD → increase of output and pressure towards appreciation, at the same excess demand for money and pressure towards interest increase → Central Bank must intervene, buying foreign assets to increase money supply (and to keep fix) → shift of AA → further increase of output, ExR remains at fix

• Fiscal policy has an impact on output (and employment)

Stabilization policies under fix (3)

• Changes in ExR, assume that Central Bank is credible, i.e. people accept new expected ExR immediately

• Devaluation → increase of exports and AD (why?) → increase of output, excess demand for money, pressure towards interest increase → Central Bank intervention, buying foreign assets → expansion of money supply, shift of AA, new equilibrium

XII.6 Conclusions for stabilization policies

The efficiency of fiscal, monetary and trade policy differs according the exchange rate regime

• Flexible exchange rate (float)– Fiscal policy very little efficient– Monetary policy very efficient

• Fixed exchange rate– Fiscal policy very efficient– Monetary policy very little efficient– Changes in ExR efficient

Literature to Ch. XII

• Krugman, Obstfeld, ch.15-17. Basic text and references there.

• Dornbush, Fischer, ch. 6. Slightly different way of explanation, but it might seem more comprehensive to some